There's No Rationale For Owning Gold Mining Equities – It's As Close As You Can Get To Insanity! Here's Why

Hedge fund manager Hugh Hendry has stated, “There is no rationale for owning gold mining equities. It is as close as you get to insanity. The risk premium goes up when the gold price goes up.” Indeed, the notion that adding gold and other commodities to one’s portfolio produces a higher expected return with lower risk failure has failed of late and can be illustrated through the following charts. Words: 808

So says Brennan Basnicki (http://tradersvideoplaybook.com/) in edited excerpts from his original article* posted on Seeking Alpha entitled The Fallacy Of Owning Gold Mining Equities.

Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), may have edited the article below to some degree for length and clarity – see Editor’s Note at the bottom of the page for details. This paragraph must be included in any article re-posting to avoid copyright infringement.

Basnicki goes on to say, in part:

Ample research supports the notion that the addition of gold and othercommodities to one’s portfolio produces a higher efficient frontier — or more plainly stated, a higher expected return with lower risk….While this approach may have worked at lower gold prices, it has failed since early 2011, when gold traded around $1400. Not only has this approach failed, but gold miners have been one of the poorest performing sectors….

Performance of Gold Miners vs. Gold

The first chart shows how poorly gold miners (GDX) and junior gold miners (GDXJ) have performed compared to gold (GLD). Note that while gold is up over 25%, junior gold miners are down 45%!

Performance of Gold Miners vs. the S&P 500

One can often blame the equity market for underperformance in gold miners versus gold, as miners are companies with earnings, and when equity markets are weak, most stocks are weak. However, if one compares the GDX and GDXJ to the S&P500 (SPY), this argument collapses. Not only have gold miners underperformed gold, they have also significantly underperformed the S&P500!

Correlation Between Gold Miners (GDX) & Gold

The idea that one can gain exposure to gold through mining companies clearly has not held. A look at the correlation between the miners and gold shows the failure of this historic relationship. The below chart shows the correlation over the last 20, 50, and 100 weeks between gold and gold miners. Note that while although the correlation remains high over the shortest (20 week) period, over the long term (100 weeks), the correlation has trended to zero.

Correlation Between Junior Gold Miner ETF (GDXJ) & Gold

The case is even worse for the junior gold miners ETF. The correlation moved into negative territory:

Why has this relationship changed? I don’t have the answer to that, but one potential source of the discrepancy is that as gold reached historical highs at the end of 2010, mining companies may have increased hedging activities. This would obviously limit their ability to participate in any gold appreciation above that level ($1400).

The eccentric hedge fund manager Hugh Hendry makes a different argument for further weakness in gold mining stocks, having stated that:

“There is no rationale for owning gold mining equities. It is as close as you get to insanity. The risk premium goes up when the gold price goes up. Societies are more envious of your gold at $3000 than at $300 – and there is no valuation argument that protects you against the risk of confiscation.”

Basically, the more expensive gold is, the higher the probability that gold mines will be nationalized. This leads to a higher risk premium required for gold miners and accordingly, a lower stock price when completing any sort of fundamental valuation.

The paradox is that if nationalization continues, the market ends up with less supply: a public government will not be nearly as efficient as a private company. Less supply means higher prices and accordingly, a higher probability of further nationalization. While nationalization may only be possible in developing countries, higher tax rates or government royalties are equally likely in developed countries. Recent examples of such actions include the ongoing dispute over Kyrgyzstan’s gold and Venezuela’s move to nationalize gold just over a year ago.

While I’m sure there may be evidence to counter this argument, the failure of miners to participate in gold’s appreciation above $1400 does support this. I am not an expert in gold, however, I have spent significant time studying technical analysis. One thing you learn early in technical analysis — and probably one of the most important rules is that “the trend is your friend” — simply implying that you always want to position yourself alongside the trend. Well, the trend has been towards less and less correlation and underperformance for gold miners. Hendry himself is long gold and short gold miners. Until new evidence is available of a change in this relationship, it is likely that the current trend will persist.

Conclusion

To return to portfolio management, it should be clear at this point that the addition of gold-related equities does not raise the efficient frontier (higher return with lower risk). One should look at allocating a portion of their portfolio to outright gold exposure, either in the form of a gold ETF such as GLD, or even physical ownership….

Editor’s Note: The above post may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

You have probably read in multiple articles that mining stocks offer leverage to the movement of the underlying metal. This hasn’t been the case over the past several years, however, which has created some confusion in the precious metals investment community. While the gold price has more than doubled (+110%) in the past five years, the AMEX Gold Bugs Index (HUI) is up only 15% so why do people keep saying that mining stocks offer leverage? Well, because they do during certain periods of the bull market. [Let me explain the situation more fully and exactly where we are in the current bull market.] Words: 677

For the past eighteen months, gold stocks have been pummeled…What’s going to move these darn stocks? Will their day ever come? Could our research – gulp – be wrong? Jokes have even started circulating…[such as] a) What’s the difference between a seagull and a gold stock investor? The seagull can still make a deposit on a Mercedes. b) Gold equities may be bad, but I slept like a baby last night. I woke up every hour and cried. Laugh or cry, however, underneath this heap of stock-certificate debris is the contrarian opportunity of a lifetime. That’s a strong statement, I know, but below I present numerous well-researched reasons why I’m convinced gold stocks are one spark away from igniting the portfolios of those with the cash to buy, courage to act, and patience to hold. Words: 2800

<img width=”90″ height=”65″ src=”http://www.munknee.com/wp-content/uploads/2011/10/171686-gold-silver-bars-90×65.jpg” alt=”171686-gold-silver-bars” title=”171686-gold-silver-bars” />Gold & silver have pulled back over the past two weeks after both faced strong resistance from the upper horizontal line of their respective trading ranges [and continue to flucuate within their] 12-month Trading Ranges of $1,540 – $1,800 and $26.50 – $36 respectively. HUI and XAU levels have pulled back and are testing the lower boundary of their rising wedges [but look likely to move upwards within their respective wedges (530 – 570 for the HUI and 200 – 215 for the XAU) before moving higher]. Check out my technical analysis below for details.

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